Surging Asian inflation could hit Western markets
While Western investors are preoccupied with ongoing discussions about escalating financial woes, a recessionary US economy and rising inflation, the consequences of surging Asian inflation have received relatively little coverage.
The upshot of rapidly rising inflation in Asia could not only result in stronger Asian currencies, but also in reduced Asian investment in Western bond markets and, over the longer term, the need for higher real rates in the West with commensurate implications for lower economic activity.
This scenario was very succinctly argued in a recent research report by Pierre Gave of investment house GaveKal. His views are repeated below.
For the past year, we have warned that rising inflationary pressures in Asia could trigger a change in Asian monetary policy. The idea was fairly simple: If Asian inflation continued to creep up, then Asian policymakers would have little choice but to let their currencies appreciate. And in so doing, they would no longer be forced buyers of US and EMU bonds. This would be especially likely if food inflation took off, since the tolerance for rising food prices is very low in the emerging markets of Asia.
We first saw this unfold in India: Frustrated by the inability of conventional tightening measures to combat inflation, Indian policymakers decided to let the currency appreciate. In the second and third quarters of 2007, the Indian rupee was one of the best-performing currencies in the world, gaining 11% against the US$. As a result, Indian inflation fell from 6.7% to 3.0% in just eight months. At the time, the question was whether inflation would spread to the rest of Asia – and, if so, how other Asian policy makers would react.
Recent months have provided a clear answer to that question: Asian inflation is undoubtedly on the rise. China recorded a 7.1% year-on-year gain in consumer prices in January, the highest inflation rate since September 1996. In Singapore, CPI growth accelerated to 6.6% year on year in January, the fastest pace since 1982 … In fact, wherever you care to look, prices in Asia are clearly moving higher, mostly because of a massive rally in soft commodities.
With the above in mind, we should not be surprised to see Asian currencies rise more aggressively in the near future. For example, the market has now massively adjusted its expectations of future Chinese renminbi appreciation.
Given the rising inflationary pressures, we fully expect Asian currencies to appreciate at a faster rate. And as this happens, Asian central banks (followed by Asia’s private savers) will export less capital into the bond markets of the West. This will mean higher real rates in the West, as well as a collapse in monetary aggregates. In turn, this will most likely trigger a big drop in economic activity.
Of immediate consequence: be very careful of overvalued US and EMU government bonds.
Source: Pierre Gave, GaveKal – Ad Hoc Comment, February 29, 2008.
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